When Debt Is a Good Thing

Earlier this week, I discussed why investing in highly indebted companies is one sure way to sink your portfolio. As I expected, I got a flurry of emails asking me what debt levels are acceptable for various companies in various industries and if I have a certain debt percentage that I stick to.

The common mistake many investors make is looking at debt as a percentage on a balance sheet as opposed to a source of capital for a business. In other words, the indebtedness of a company should be viewed in the context of the cash flow statement. Since the use of debt capital is a financing decision, one needs to look at the cash flow statement in answering the question of whether or not debt is a good.

Generally speaking, debt is the optimal source of capital when you have a business that produces tons of free cash flow and requires very little capital expenditures (capex). The reason why leverage is so tempting to people is that it magnifies upside returns. Where leverage turns deadly is when things go sour and you are forced to liquidate to raise capital. A business with minimal capital expenditures and ample free cash flow generation doesn't face those sort of problems, so the use of debt financing, especially in today's low interest rate world, is fantastic.

Warren Buffett used massive amounts of leverage to take Berkshire Hathaway (BRK-A) from a million dollar small-cap company to a multi-billion dollar large-cap giant. What Buffett did differently was utilize insurance premiums, also known as float, as his form of leverage. If the insurance operation is sound, as it is for Berkshire, he often pays 0% for the capital. Buffett is an extreme example, but a noteworthy one nonetheless.

For businesses such as Microsoft (MSFT) or Google (GOOG), which generate cash and have few expenditures, it does make sense to use traditional forms of debt. When a company generates strong levels of free cash flow, say a 10% unlevered free cash flow, a leveraged balance sheet is the optimal structure. Microsoft pulled in nearly $30 billion in free cash flow in 2011 against $2.3 billion in capex. That's why Mr. Softee now spends over $6 billion a year to pay a dividend. For years, Microsoft was a debt-free company; today the company has more than $12 billion in debt. Microsoft could easily absorb another $20 billion in debt if the company had something intelligent to do with the money.

A capital intensive business on the other hand should be very attentive to its use of debt capital and that's often where you find the biggest blow ups. Management teams, hopeful they are making a "value maximizing" acquisition (or other strategy), go out and borrow to do so. Occasionally, this path works, and the stock surges. The vast majority of the time, however, the company finds itself having to shore up capital by either selling assets or new equity at unattractive prices, neither which is good for shareholders.

Railroads and utilities are the types of capital intensive businesses that have the ability to support higher levels of debt. Retailers would not be good candidates for highly levered balance sheets. There are exceptions everywhere, of course: auto parts retailers can support more leverage than a fashion retailer, for example. AutoZone (AZO) has been a stellar investment for many years because the company used prudent levels of leverage to buy back tons of shares over the past decade. Stein Mart (SMRT) in an attractive discount fashion retailer because it employs no leverage in running the business. So when times get tough or consumers spend less, it doesn't have to worry about the creditors knocking.

When you think about debt and its uses, think about the business and its operating structure and not a debt percentage. I would rather own a levered business generating lots of free cash flow than a less leveraged business that is capital intensive.

Get an email alert each time I write an article for Real Money. Click the "+Follow" next to my byline to this article.